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VOLUNTARY DISCLOSURES and EARNINGS SURPRISES: the CASE of HIGH-TECH FIRMS in PERIODS of BAD ECONOMIC NEWS John Shon, Fordham University

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VOLUNTARY DISCLOSURES and EARNINGS SURPRISES: the CASE of HIGH-TECH FIRMS in PERIODS of BAD ECONOMIC NEWS John Shon, Fordham University ACCOUNTING & TAXATION ♦ Volume 1♦ Number 1♦ 2009 VOLUNTARY DISCLOSURES AND EARNINGS SURPRISES: THE CASE OF HIGH-TECH FIRMS IN PERIODS OF BAD ECONOMIC NEWS John Shon, Fordham University ABSTRACT In this study, I examine the voluntary disclosure behavior of high-tech firms experiencing bad economic news. I create a sample of 100 randomly-selected firm-quarters with negative returns—but not necessarily negative earnings surprises. I find that: (i) the unconditional relation between earnings surprises and voluntary disclosures is non-existent in this setting where negative stock returns are controlled for, but (ii) firms with negative earnings surprises make forward-looking statements with more negative information content—but only when conditioned on firm size or growth opportunities. Sample selection procedures can therefore affect inferences drawn from voluntary disclosure behavior documented in extant studies. Conditional analysis reveals how the earnings-disclosure relation cross- sectionally varies with firms’ economic characteristics. JEL: M40, D82 KEYWORDS: Voluntary disclosures, earnings surprise, bad economic news, litigation risk INTRODUCTION n this study, I examine the voluntary disclosure behavior of firms with bad economic news. The goal of the study is two-fold. First, I examine the relation between voluntary disclosures and earnings Isurprise —but do so only after explicitly controlling for negative stock returns. Controlling for negative returns is particularly important for studies that examine bad news disclosures because they are a necessary condition of Rule 10b-5 litigation. Other studies fail to control for this, and may suffer from a correlated omitted variables problem; such studies may therefore draw incorrect inferences about the earnings-disclosure relation, or find results that are inconsistent with litigation predictions. My second goal is to examine the cross-sectional determinants of the earnings-disclosure relation. That is, does the earnings-disclosure relation systematically vary across different economic settings? For instance, a firm with relatively high growth opportunities may exhibit an earnings-disclosure relation that is quite different from that of a firm with relatively low growth opportunities. This conditional analysis provides a deeper understanding to our current knowledge of how earnings surprises affect voluntary disclosure behavior, and sheds light on why prior studies may find conflicting results. I randomly select 100 firm-quarters in high-tech industries that experience negative market-adjusted returns during the quarter. Because I do not impose requirements on earnings, the firms do not necessarily exhibit a negative earnings surprise. I collect the voluntary disclosures made during the quarter for each of these firms, and then examine the possible sources of variation in the number and information content of these disclosures. I estimate a model of voluntary disclosures regressed on earnings surprise—and interactions of the surprise with economic characteristics. I find the following results. First, I find that earnings surprises are not related to the number of disclosures in any meaningful manner. Second, related to the interaction terms, I find that firms with more negative earnings surprises make forward-looking statements with more negative information content—but only when conditioned on firm size or growth opportunities. That is, negative earnings surprises have an impact on the disclosure decision, but only for firms that are large in size or have high growth opportunities. Conversely, negative earnings surprises do not seem to affect disclosure behavior for firms that are small in size or have low growth opportunities. 1 J. Shon AT♦ Vol. 1 ♦ No. 1 ♦ 2009 Since unconditional earnings surprises are found to have no relation to information content, this result highlights the importance of the conditional analysis. One empirical result that consistently emerges from my analysis is the absence of an unconditional relation between earnings surprise and voluntary disclosure behavior. This is most consistent with the findings of Lang and Lundholm (1993) and less consistent with the findings of, e.g., Skinner (1994) or Miller (2002). Specifically, Lang and Lundholm find a positive relation between earnings and disclosure quality, but find that this relation ceases to exist when stock returns are subsequently controlled for— perhaps because “returns capture the relevant information in earnings.” In this study, the sample requirement of negative stock returns likely has a similar effect on the unconditional earnings-disclosure relation. This highlights the importance of avoiding earnings-based metrics in the sample selection procedure, and how this issue can have a nontrivial impact on the inferences that are drawn from certain disclosure studies. It also sheds light on one possible reason why prior studies like Francis et al. (1994) and Skinner (1997) find control firms with negative earnings surprises that do not make voluntary disclosures in the manner that litigation-risk-based hypotheses would predict—the negative earnings surprises may not translate into comparable stock price declines, which is a necessary condition for Rule 10b-5 litigation. The results in this study therefore suggest that future research on the earnings-disclosure relation should control for stock returns, and explicitly consider how the earnings-disclosure relation may cross-sectionally vary across firms. Results in this study should, however, be interpreted with caution because, given the industry membership and negative stock returns requirements I impose on my sample, the disclosure behavior I document may not be generalizable to the broader universe of firms. The paper proceeds as follows. In the next section, I review the relevant literature. Next, I discuss the sample selection process and research design. The following section presents empirical results. Lastly, I discuss conclusions and caveats. LITERATURE REVIEW In this study, I examine the relation between voluntary disclosures and earnings surprise for firms experiencing bad economic news. A large number of studies investigate the voluntary disclosure behavior of firms that experience bad economic news (e.g., Skinner, 1994, 1997; Francis et al., 1994; Kasznik and Lev, 1995; Aboody and Kasznik, 2000). The most prominent economic force examined in extant literature is litigation risk under SEC Rule 10b-5 (e.g., Trueman, 1997; Johnson et al., 2000), which states that it is unlawful for a firm to make an “untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements [previously] made… not misleading.” Because managers have an asymmetric loss function, when they possess “sufficiently bad” news, they have an incentive to ex post voluntarily disclose the bad news in a timely manner to reduce expected litigation costs. Timely, curative disclosures (i.e., those that exhibit negative information content) reduce expected litigation costs because such disclosures counter allegations that the news was not released in a timely manner, and also reduce the class period and class size of potential lawsuits. Anecdotal evidence suggests that many Rule 10b-5 lawsuits are triggered by negative earnings surprises, so many disclosure studies use earnings surprise as a proxy for litigation risk and examine whether such earnings surprises are related to different levels of disclosure. Most disclosure studies therefore use earnings surprise as a proxy for litigation risk and examine whether negative earnings surprises are related to higher levels of disclosure. For instance, both Skinner (1994) and Kasznik and Lev (1995) find that firms with bad earnings surprises are at least twice as likely to provide voluntary, preemptive disclosures than those with good earnings surprises. This suggests that bad earnings surprises increase expected litigation costs (relative to good earnings surprises), and that firms increase preemptive disclosures to reduce such costs. However, other studies like Francis et al. (1994) find that for the majority of 10b-5 lawsuit firms, preemptive disclosures are not the panacea for litigation, but rather, the precipitating factor 2 ACCOUNTING & TAXATION ♦ Volume 1♦ Number 1♦ 2009 for it. Meanwhile, virtually all of the control firms in their sample (“at-risk” of litigation, but not sued) make no preemptive disclosures—though the at-risk firms exhibit a much more severe earnings decline (similarly, Skinner, 1997). Since preemptive disclosures should reduce litigation risk, not be the precipitous factor for such lawsuits, these studies are inconsistent with the notion that negative earnings surprises increase litigation risk. Moreover, there are other studies that find a positive earnings-disclosure relation because earnings surprises are considered good news (e.g., Miller, 2002) and fit into the typical motivation for the disclosure of good news (e.g., Verrecchia, 1983; Dye, 1985). And yet others find no relation (e.g., Lang and Lundholm, 1993). One possible explanation for these conflicting results is that, because of the noise and bias in GAAP, a negative earnings surprise does not necessarily suggest a short-term price decline (e.g., Kinney et al., 2002). This is a non-trivial point when considering bad news disclosures because the short-term price decline is a necessary condition for Rule 10b-5 litigation (e.g., Jones and Weingram, 1996), which is the main motivation for bad news
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